I often hear the complaint that the economy "isn't working right" or that it is "not working the way it should". we hear this sometimes in terms of the housing crisis, or in terms of unemployment, or interest rates. And the proposed solution is often that we need more government interference.

Of course, the reality is that the market is working exactly the way it is supposed to, it simply is not behaving in a way pleasing to the speaker. Oh, sometimes the market is adjusting itself following government meddling, as when it responds to interest rate changes from the Federal Reserve, but, unless laws are in place to distort it, the market always behaves "as it should", even if it causes some people harm.

And that, truly, is what these neo-technocrats¹ mean when they say that the "economy isn't working". They mean that the results the free market generates are displeasing to them, or to a select group, or that they are unhappy that sometimes the market results in outcomes which cause suffering to some. Their real goal is not to produce efficient outcomes, but to produce outcomes which avoid any harm, or which favor them or some select group.

But let us ignore that for the moment and assume that they are completely sincere. Let us imagine that, by some standard, the market is not performing the way it "should". The question remains, can government interference resolve these imagined problems? Or is the cure worse than the disease?

An illustrative example is to be found in the Federal Reserve. I will spare my readers a lengthy essay on the history of banking² and stick to a short summary.

Prior to the institution of the Federal Reserve, the banking industry in the US was publicly viewed as "free", though the hideously misnamed "free banking system" actually consisted of a government imposed scheme designed, ostensibly, to control monetary inflation, but, in reality, designed to increase demand for government bonds³ while doing little to reduce inflation. The pre-Federal Reserve systems varied greatly, some were more free, some less, but there was not a truly free period for banking following the Jackson/Polk era, and, even then there was a patchwork of state regulations in place.

Regardless, the banking systems before the Fed were definitely less regulated than after, and, more importantly, the public perceived the system as unregulated. So, when the government promised to step in with the Federal Reserve, their argument was that the free market had failed⁴, resulting in bank runs and market crashes, and that a government managed currency would both prevent the bank crises that had characterized free markets and would so structure the money supply that we would be guaranteed continuous growth.

The problem is that it just failed to live up to the promise. Again, I will skip the technical arguments against a centrally managed banking system and simply point to the world wide collapse of 1929-1932, and the subsequent depression. Some will argue that it is unfair to lay at the feet of the Fed, as it was started by foreign banks, but, in reality, it is far from unfair. As the world had pinned most of its currency to the pound at the time, and the pound was tied to the dollar, the crash of 1929 may have started in Austria, but it was a result of Fed mismanagement. (I have horribly oversimplified things here in the interest of saving space. For a good analysis by someone who was there working in banking at the time, read Benjamin Anderson's Economics and the Public Welfare.)

Even if it weren't, the fact that we were plunged into such a bad depression following the creation of the Federal Reserve gives lie to the claim that managing money centrally would avoid bank panics. Whether 1929 can be blamed on the Fed or should be blamed on foreign banks does not matter. The original claims were that the Fed would prevent such crises, yet only 15 years after it was founded we had a catastrophic market crash followed by the longest depression in US history. Hardly a ringing endorsement for managed money.

However, despite the failure of the Fed to live up to its initial promises, the system was not scrapped.⁵ The argument developed that ti was not the Federal Reserve that failed. Instead, the argument went, the Federal Reserve was unable to sufficiently manage currency, as it was tied to the "anachronism" of a gold standard⁶. And so began our slow movement off of the gold standard. First, FDR outlawed the holding of monetary gold, then gold redemption was limited to foreign governments, and, at last, Nixon took us off the gold standard entirely, and we were left with a currency without any backing. The Federal Reserve had no restrictions on its ability to manage the currency.

So, once the Federal Reserve had total freedom in managing our currency, did it finally live up to those initial promises?

Well, we didn't have a crash in 1974, so I will give them that. Beyond that... Well, it is hard to find anything else to say. At least nothing positive comes to mind.

The 1970's, the first decade where the Fed was not hindered by the gold standard, were characterized by out of control inflation more than anything else. Not just at home, but also abroad. As so many nations had tied their fortunes to the dollar, our inflation often spurred inflation in other nations. Of course, some took advantage of this inflation to launch a more inflation of their own, resulting in the hyperinflation we saw in Argentina and other nations⁷. But even nations which exercised restraint were still harmed by the inflating US dollar, as IMF rules required them to ensure their currencies maintained certain trading ratios relative to the dollar. Only after some nations decided to ignore these rules did US inflation stop driving world-wide inflation.

Nor was the inflation of the 1970's the only case of the Federal Reserve still failing to live up to promises, despite being cut free of the gold standard. We have the recession of the early 1980's, the dot com crash of the late 1990's,  the minor recession Bush inherited from Clinton, and the housing "crisis" of today. All of which should not be possible under a "managed" currency, according tot he claims of the original proponents of the Federal Reserve.

Of course, just because their claims were excessive, that does not mean that the Fed did not do some good. Though I am making a lot out of the original claims, I have to admit that a much more fair test would be to compare the Federal Reserve to a free banking period. Of course, the US never really had a free banking period, so I will have to compare it simply to the less regulated era that came before.

 Even there, the Fed does not impress. Both the depression of the 1930's and the inflation of the 1970's are unprecedented, even the results of the "land bank" fiascoes during the colonial era do not compare to these two events. There are simply no crises during the more free eras which can compare to the crises created under the Fed's rule. Nor did the pace of lesser crises slow at all. As I said, the earlier system was still heavily regulated, and designed to monetize government debt, so it too was an inflationary system and subject to cyclical crashes⁸ , crashes which the Federal Reserve was supposed to correct. However, looking back over the historical record following the civil war, it does not appear that there was any substantial change one way or the other in the rate at which recessions occurred. Bank panics became a thing of the past, as FDIC and FSLIC made depositors less concerned about losing investments, but otherwise federal intervention did not change.

Actually, bank runs provide a good example of how regulation made things worse rather than better. In the past, individual banks issued credit, so monetary expansion was done on a per bank basis. When an individual bank extended so much credit that depositors thought it may become insolvent, they would pull out their deposits and cause a "bank run". The fear of such bank runs often served to keep banks from over inflating the money supply.

Under the Federal Reserve system, obviously, only the Federal Reserve inflates the money supply, though banks can issue credit which serves as a de facto monetary expansion. It was through the injudicious extension of credit that modern banks risked insolvency and still faced the possibility of bank runs. To stop this, the federal government imposed two new laws. First, they revived an idea popular in the supposedly free period prior to the Federal Reserve, requiring banks to hold reserves equal to a certain percentage of their outstanding credit.⁹ In addition to this old (and largely ineffective solution) the government also created the FDIC to insure deposits.

Initially, the FDIC  was probably sold as a populist measure, not as a pro-banking one. It was intended to make sure depositors were not left destitute by a bank collapse. However, even initially, I am sure that some noticed how much it favored the banks as well. With the FDIC (and later FSLIC), the banks were not faced with the possibility of a bank run. Except for those whose deposits exceeded the limit, depositors were unlikely to care if a bank expanded their credit wisely or foolishly.  In short, where in the past depositor fears served as a check on credit expansion, the FDIC/FSLIC allowed banks to expand credit as they wished without worrying about a bank run. The supposed safeguard actually made catastrophe not only more likely, but also ensured it would be much worse when it happened¹⁰.

But enough about the Federal Reserve, as I did not intend to write an essay on banking.

What the example above was intended to show was that federal intervention more often than not creates problems worse than it was supposed to solve. Even if one grants that the outcomes dictated by the market are not ideal (whatever that may mean), any attempt to solve them using the government almost always end up worse.

The reason is not hard to see. The economy is massive and complex. Each individual pursues their own, ever shifting desires, constantly evaluating their options, constantly reassessing the value they place on any given object. There are regularities, but most are only apparent in hindsight. If the economy were as regular and predictable as technocrats claim, then they would all have made a fortune in stocks. The truth is that economic forces do have relatively foreseeable results, but which forces are active is often only foreseeable after the fact.

Let me give one example.

The profession of farrier¹¹ was once a relatively highly paid field. During the colonial era, horses were not uncommon, and those who could not only make shoes, but properly apply them to the hooves were not all that common, so they drew a fairly high salary. As they increased in numbers their wages would fall, and as horses grew more common, their salaries would rise. For a long time these were the only two factors influencing farrier salaries. Then came mass production, including the mass production of horseshoes, making half of a farrier's job obsolete. Salaries fell greatly. Shortly after that came an even worse blow, the invention of the automobile, which made farriers almost obsolete. Excepting for a few rural areas, farriers were probably driven from business entirely.

One would expect that to be the end of the story, a horse-related profession destroyed by the car, but it isn't. As horses have become something of a status symbol, and our wealth has allowed many more of us to own horses as a luxury, the profession of farrier has seen something of a renaissance. They are nowhere near as numerous as they once were, but, as they are rare, and provide what amounts to a luxury service, their salaries are relatively high.

My point? All of this is perfectly explained by economics. And, for the technocrats that means that it all is foreseeable. My argument is the opposite. Yes, in hindsight we can see all of it, but I doubt anyone in 1865 would have guessed that either the automobile would kill off farriers or that they would later revive as a luxury service. Yes, there is a regularity and predictability to economics, but only if we have perfect knowledge before the fact. As we do not, scientific economic management is not possible. And, as we cannot manage "scientifically" as the technocrats claim, we are left with government management working at least as imperfectly as the free market. With their claims of scientific, dispassionate management no longer viable, there are few reasons to think the state would work better than the free market.

Even if we were somehow in possession of perfect foresight, would the technocratic model work? Would the government be able to manage the economy better than the free market?

I think not. Despite the claims of the technocrats (both the ones from the 1920's and those today who espouse their theories, if not bearing their name), there is no reason to think that the state will be able to dispassionately and disinterestedly maintain the economy. Even if we allow that the state could somehow obtain perfect foreknowledge, and that it could somehow use that to find a "better" solution than the free market would, the question remains, would the state do so? I argue it would not.

To return to banking for an example, let us look at the boom/bust cycle.

Many argue that the cycle is inherent in the free market, or, at least in a free market with fractional reserve banking. But that is simply untrue, as one can see  in the few free banking systems which have existed (eg. Scotland prior to the Bank of England entering and controlling the market).  Under a free banking system, it is possible a single bank, or maybe even a small group, may expand credit excessively, but they would then face bank runs and either have to rein in their lending, or face bankruptcy. This sort of mistake would cause some small problems, but would not lead to the sort of boom/bust cycle we know.

The modern boom/bust cycle exists only when there is a centralized state control of banking, either in the form of direct control (eg. the Bank of England or the Federal Reserve), or through regulations which create a consolidated banking system (such as the pre-Federal Reserve system which allowed multi-tier inflation on top of specific regional banks, all resting on top of select New York City banks). Without that centralization, it is almost impossible to create a general over-expansion of credit, and it is certainly impossible for a free market to generate the cyclical over-expansions needed for the boom/bust cycle.

Then again, the boom/bust cycle is not inherent in centralized banking either. There is no need for banks to over-expand credit regularly, leading to the boom/bust cycle. The present boom/bust cycle is not inherent in central banking, it is the outcome of non-economic considerations¹². Two pressures predominate in creating this cycle. First, there is the pressure to keep the economy growing. The second is the political tendency to favor debtors over creditors.

The first pressure is obvious from any news report mentioning the Fed. The talk is almost always about cutting interest to keep the economy growing, while avoiding "inflation"¹³. It is this myopic focus on growth above all that distinguishes the Fed from the bankers it replaced. Bankers would not simply expand credit without thought of other matters, while the pressure on the Fed is in that direction. A banker, making decisions for his small bit of the economy, would balance his credit expansion against the needs to retain solvency. The Fed has no such concerns, and, as it will take the blame for deflationary pressures, has an interest in nothing but monetary expansion. The political pressure is to give the appearance of supporting growth, even if that means a relatively reckless rate of monetary growth. No one worries about the inevitable crash, so long as they can take the credit for the preceding boom¹⁴.

The other pressure on the Fed works in the same direction. Politicians, of necessity, prefer policies which favor debtors over creditors¹⁵. I know that the Fed is supposedly independent and not subject to political considerations, but does anyone believe that they really take no notice of pressures from the president or congress? If the politicians favor inflation as a way to grant backdoor debt relief, I am certain that they can find a way to get the Fed to play along. And, just as with the pressure for continual monetary growth, the pressure to inflate to aid debtors will also feed into the process which produces the familiar boom/bust cycle.

To summarize, the attempts at scientific, rational control of the economy, substituting government control for the "anarchic" free market have failed repeatedly. Such failure was inevitable, as the perfect knowledge which was needed is impossible, and, even were it available, government regulators are subject to political, non-economic considerations which can lead easily to very bad decisions.¹⁶

"So," some of you are thinking," regulation has problems, but does that mean the free market is any better? What makes the free market so special? Isn't it just as flawed?"

I could cop out easily and say that much better men than me have written thick volumes arguing that point, and I hardly have the time fr space to repeat those efforts¹⁷, but that would be a bit unfair. So, allow me to make a very brief argument in favor of economic freedom.

The basic advantage of the free market is the minute division of labor. Each individual knows best what he wants, and he alone is in charge of pursuing his own interests. Of course, he satisfies his own wants best if he controls more resources, and the way to do so is by providing something more of his fellows want than anyone else. This inspires him to help others solely to satisfy his own desires. In the end, the one who best predicts what others want ends up with the most resources, both to satisfy his own wants and to expand the services he provides to others. In  the long run this tends to allocate resources most efficiently, at least if we define efficiency as providing the greatest net satisfaction of the wants of the individuals in the economy.

Obviously there are a ton of assumptions in that statement. I assume we want the economy to satisfy the wants as understood by the participants, rather than providing what someone else deems is good. It assumes that inequalities of income are acceptable. There are endless assumptions. Nor did I even delve into the way the free market provides tools such as prices, to simplify the determination of collective valuations. There is just far too much to say in such a short space.

That is why I hesitated to even offer a defense of the free market. To defend it we need to agree on a certain basic set of assumptions. I think most of us share those assumptions, but I may be wrong.

So, perhaps it is best if I just leave it at that. I think I have done a fair job of showing how, even measured by their own standards, government management of enterprises fails. That was my main point. I also think that the free market will easily outperform the state but to prove that would take much more space than I want to use here.

Perhaps I will defend the free market in my next essay. If not, then in a day or two. It really deserves its own essay.

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1. The original technocrats were a political movement of the 1920's and 1930's who thought that the economy should be "scientifically managed" for the good of all. Some took this in a more Marxist sense, some in a more Fascist sense. They largely vanished by the time of the Second World War, though, in some ways, the "brain trust" around FDR shared some of their ideas, if not their ideology. I am aware that (as of 1988) there was a lone remnant of the movement, a single old man making up a movement called "Christian Technocracy", which combined white supremacy, technocracy and pseudo-Christianity in a rather ugly doctrine. I wrote to him when I was writing to various radical groups, and still have his manifesto somewhere in my basement.

2. This promise applies only to this essay. I make no promise that I will not eventually subject readers to a long and boring history of banking. I am just refraining from doing so for the moment.

3. It is an interesting feature of both the Federal Reserve and its predecessors that they created an artificially high demand for US treasury notes. Some of the previous systems by allowing government debt to be used in lieu of specie to cover credit expansion, the Fed by using various practices to "monetize" debt, using the government's debt to increase money supply. It is not important for this essay, but at some point, if we ever want to balance our budget, we need to create a banking system which does not demand an ever increasing federal debt.

4. This reminds me of the arguments about airline and utility "deregulation". The failures of government regulation are often laid at the feet of capitalism. This is most often the case in mixed systems, such as pre-Fed banking, where the public does not see the degree of government regulation, making it easier to blame failures on the (apparently) unregulated industry, while the blame more properly belongs to the much less obvious regulations.

5. It is very unusual for any government program to be scrapped because of simple failure. Instead, failure is usually interpreted to be due to a lack of funding, or not being granted enough authority. As in this case, that usually results in giving the failed project even more power. It is ironic, but in government, the less successful a project is the more money and power ti will be granted. (Which is one fo the reasons I am very leery of government solutions.)

6. Many writers, much more competent than I am, have written on the advantages of the gold standard. Perhaps one day I will try my hand at making a pro-gold argument. For the moment that is not relevant. All that matters here is that the Fed's failure was blamed, not on the theory being incorrect, but on the remaining gold standard, and the fed was allowed to continue to the present despite an inability to live up to the original claims.

7. Of course, some nations were inflating prior to the US launching its own inflationary plans, but even then the US inflation did them no favors, as world currency was tied to the dollar.

8. Despite conventional wisdom, cyclical crashes are not inherent in a free economy. Fractional reserve banking does not necessitate boom/bust cycles. Actually, neither does a managed currency, but the reality is that debtors outnumber creditors, so the pressure on the government is always to favor debtors, which means monetary expansion, resulting, inevitably in the familiar boom/bust cycle.

9. Differing definitions of what would qualify as reserves was one fo the distinguishing features of the various pre-Federal Reserve banking systems. Some required all reserves be in gold. Otehr accepted a tiered system, where banks in one tier could count reserves in a higher tier bank as reserves, allowing for a pyramiding of inflation, as deposits in some banks could be used to secure credit in that bank, as well as in the bank which had made the initial deposit.

10. I have written on this before when discussing the way that the free market is often blamed for regulatory measures. In that essay I failed to state it as clearly as I did here.

11. I have to confess I misspelled this word "ferrier" in a comment where I used this example. Obviously the whole iron working aspect was influencing my choice of spelling. But, as I have made such an issue of spelling, I feel the need to admit my own mistake here. Oh, and for those unfamiliar with the word, a farrier makes and applies horseshoes. Modern farriers also tend to address other problems with hooves, but traditionally their field was limited to making and attaching shoes.

12. The boom/bust cycles of the pre-Fed system were created by different pressures. Mainly by creating a system which favored inflation and also hid some essential information from those making decisions. For example, by allowing a bank to count reserves held in another bank as security for credit, it made it impossible for the bank to know how much credit that reserve actually supported. A banker knew how much credit he had based on it, but could not know if the other bank had also used it to create credit, or even had deposited it at a bank on an even higher tier which also used it to inflate. The system itself made inflation impossible to control.

13. This is yet another example of journalists' inability to understand economics. They speak of lowering interest rates while avoiding inflation. But the fact is, to lower interest rates, the Fed inevitably engages in monetary inflation. Their myopic focus on price inflation rather than recognizing the changes to money supply results in very misleading reports when it comes to the Fed.

14. It is amusing that politicians and the Fed always take credit for the "growth" they cause, yet the bust that follows is always blamed on "the market". Apparently growth is caused by politicians and crashes are just part of the free market.

15. The populist line used by most politicians involves small business owners or farmers being exploited by greedy banks, but the truth is that most huge companies are actually deeper in debt than small businesses. In fact, inflation tends to help the wealthiest companies, as their bonds are paid in heavily devalued dollars. Not that politicians care, as they can pitch inflation using populist rhetoric, while also doing favors for big corporations who will actually profit from the deflation. It is a win-win for the politicians. Oddly enough, most of those bonds, now worth much less due to inflation, are held by the very people who are taken in by the populist rhetoric. Of course, the biggest winner of all is the biggest debtor of all, the US government, which can now repay creditor in deflated dollars. Which makes inflation by the government seem a pretty selfish gesture.

16. I know I have written quite a bit, and it is possible that I either omitted something or made a misstatement, so I do apologize in advance. As I was working while writing this, I have not  had time to adequately proofread. So, please, if you find any errors, let me know.

17. For those who do want to read such a voluminous defense, I recommend von Mises Human Action. I will warn readers than most of the book is dedicated to a very detailed explanation of the science of economics, starting from the most basic foundations, but the final conclusions he draws form this groundwork are impressive, so it is worth the rather serious effort it takes to get through the whole thing.

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ADDENDUM

It is not relevant to this argument, but there is something I find interesting.

When the Federal Reserve was created there was some reluctance to create a European style central bank owned and controlled by the state. Questions were raised about whether or not such a creation would be constitutional, and, even if it were, would the public accept it. As a result, the Federal Reserve was created as a quasi-governmental entity. It was, on paper, just the logical extension of the prior system, but instead of pyramiding on top of a few private New York banks, all inflation would be pyramided on top of the Federal Reserve. (In addition, the issuing of notes was limited tot he Fed alone, unlike past systems.)

What is interesting is that I have read a number of conspiracy theorists who obsess over the fact that the Fed is PRIVATE. While on paper that may be true, it is hard to imagine a more government controlled entity. The Fed is almost entirely controlled by the state. Yes, once on the board they may be free of explicit influence form congress, but that is true of the Supreme Court as well, and no one is arguing they are a private business.

So, rest assured conspiracy theorists, the Fed is safely under the thumb of the state. No need to worry about private enterprise running your banks. It is wholly controlled by the state. You can rest easy.

(On the other hand, the rest of us, not bedeviled by nightmares of evil bankers scheming to rob us can worry that all things monetary are in the hands of the state. The people who organized the Bay of Pigs, Waco, and the Iranian hostage rescue are also running the nation's finances. I'm sorry, but even if banking were run by some evil Zionist cabal, I would prefer hading over control to them to letting all of our nation's finance be run by people whose sole skill is getting reelected.)